Borrowers are once again signing up for one of the risky loans that fueled last decade's housing boom -- and bust: the adjustable-rate mortgage.
After two years of little demand, ARMs, which offer borrowers a fixed interest rate for a set period, after which rates rise or fall with prevailing rates are making a comeback. For the first six months of this year, ARMs accounted for 13.4% of the total mortgage market, according to the latest data available from Inside Mortgage Finance, a trade publication. That's up from 9.5% for all of 2010 and 6.3% in 2009.
At a time when interest rates are already at historic lows and the housing market is still sluggish, ARMs are still risky, said Keith Gumbinger, vice president at HSH Associates, a mortgage data firm. An ARM has always been something of a gamble -- when the fixed term is over, if interest rates have gone up, so will a borrower's payments. With interest rates already so low, there is widespread agreement they have nowhere to go but up, taking homeowners payments right along with them.
ARMs have also been traditionally popular with homebuyers who expected to sell their house -- often at a profit -- before their fixed-rate term expired. But with the housing market still in a slump, that's hardly a slam dunk. Indeed, recent data suggests five years may be a narrow window in today's market: Homeowners who sold their homes last year stayed there for eight years on average, up from just six years in 2008, according to the National Association of Realtors.
Both of these risks converged on borrowers when the housing market crashed in 2008. Many were unable to make the higher payments and found themselves stuck in a house they could not afford and could not sell, leading to the defaults and foreclosures that have characterized the bust.
But today, rates on ARMs are so low and real estate prices are so depressed in most markets, many of the risks of ARMs have been forgotten. The average rate on a so-called 5/1 ARM -- which carries a fixed rate for five years before adjusting each following year -- is now 2.96% compared to 4.16% for a 30-year fixed rate mortgage, according to HSH Associates, which tracks mortgage data.
Lenders say ARMs are also safer now than they were during the early Aughts. Unlike during the housing boom, lenders now require high credit scores, proof of income and a down payment of at least 20%. As part of their approval process, these lenders are also now making sure borrowers can afford not only the monthly payments at the outset of the loan, but also the payments they might see if rates go up.
That's the biggest risk: that monthly payments after the reset will be too much to handle. For example, a borrower who signs up for a $400,000 5/1 ARM with a 2.96% rate will pay about $1,678 per month for the first five years. After that, if rates spike, their interest rate can jump by a maximum of five percentage points to 7.96%, and their monthly payments spike to roughly $2,733. For many borrowers, keeping up with these large payments could be difficult and falling behind would mean losing their home to foreclosure.
Before considering an ARM, experts recommend borrowers ask to see the lowest and highest possible monthly payments they could theoretically face over the life of the loan to get a better sense of whether they can afford it under a range of circumstances. One smart strategy for borrowers: Put any extra savings during the fixed term of the loan into an interest-bearing emergency fund to cover the higher costs when rates rise.